© Copyright 2000 Rogers Media. The following article first appeared in the April 2001 edition of BENEFITS CANADA magazine.

Pulling the plug on your money manager

Diligent monitoring helps pension plan fiduciaries know when it's time for a change in investment management.

By Greg Malone

These circumstances may result in uncertainty and discomfort on the part of pension committee members. But unfortunately, indecision on the part of plan fiduciaries can lead to extended periods of poor performance.

When it comes to developments within an investment firm, the first step is to assess whether the events are truly significant from a plan sponsor perspective. For example, in recent years, there have been many consolidations and acquisitions in the industry. And although they always merit serious attention, these changes are not necessarily cause for concern.

Each situation must be evaluated independently to determine the following:

• Is the corporate change likely to result in changes in key personnel?
• Will the change have an impact on the investment manager's philosophy, style or decision-making processes?
• Has the interaction among the firm's investment professionals been altered or is it likely to be affected down the road?
• Can the new entity accommodate the service requirements of the combined client base and total assets under management?

If the answers to these questions are unsatisfactory, it may be appropriate to find a new manager before adverse investment performance occurs.

However, a change in ownership doesn't necessarily have a serious impact on a manager's future performance. Often there are less obvious internal changes that must be considered.

Turnover among key professional staff, for example, always raises questions about a firm's ability to generate consistent performance. Even instability in support staff could indicate a problem. A significant increase or loss of assets under management may also spell trouble.

POLICY VIOLATION

Manager violation of the investment mandate or policy can occur either knowingly or inadvertently. Inadvertent violations should be treated with care.

For example, when a manager exceeds maximum stock or sector holding limits or violates the asset mix range, this could be the result of an active maximum allocation driven higher by market movements, which would indicate that the manager's investment bet paid off. If this is the case, the pension plan's fiduciaries should expect to hear from the manager immediately to advise them of the violation and discuss solutions.

Other violations, such as investing in restricted assets, are more serious. Any investment management firm that actively violates an investment policy should be questioned on its internal tracking mechanisms and control procedures. Unresponsiveness or refusal to address the issue may be cause for dismissal.

Occasionally, investment manager restructuring may result in a firm that no longer fits the client mandate. Assuming the mandate remains appropriate, replacement of the manager must follow.

When the cause for concern is investment performance, determining when to make a change often gets cloudier. There might even be uncertainty as to whether underperformance has actually occurred.

Understanding underperformance starts with a clearly designed investment policy that includes reasonable and appropriate performance objectives. Committee members must be comfortable with the policy decisions they have made and the implementation structures chosen to support the policy.

Finding the right managers to implement the policy means understanding the investment philosophy and style of the managers available, then choosing the ones that best suit the plan's criteria. Only those managers with a demonstrated ability to manage the chosen mandate should be considered.

One common mistake is to hire a firm based on its performance track record without fully understanding how the particular manager's style contributed to the performance. Performance objectives must reflect three key considerations: style, risk tolerance and reasonableness. For example, a small-cap U.S. equity mandate is not appropriately benchmarked to the Standard & Poor's 500 composite index. In this case, a market index comparison will only lead to erroneous conclusions and potentially inappropriate actions.

By reflecting the risk that the plan's governing fiduciaries are prepared to take, the objectives will help guide the manager's decision-making process. Fiduciaries can then determine not only if a manager's forecast was correct, but also whether the magnitude of the bets made on the basis of the forecast are consistent with the fiduciaries' understanding of the manager's investment style.

If a manager who typically makes modest investment bets predicts that interest rates will trend downward over a lengthy period, this may be reflected in adjustments to the investment portfolio. If the forecast is wrong, this may not pose a problem in and of itself.

However, if the manager went as far as to significantly overweight the portfolio in interest-sensitive stocks and lengthened bond terms, serious losses could result. This would be completely contrary to the expectations of the plan's fiduciaries who expect only modest investment bets, and accordingly, modest losses for wrong investment bets.

Performance monitoring should also include an evaluation of risk tolerance with informative risk measures. These may include a variety of volatility measures, ratios, risk-adjusted returns and stress tests. The purpose is to help the plan's fiduciaries evaluate whether investment performance is consistent with the plan's risk profile.

To be reasonable and appropriate, manager objectives should also be distinct from common performance measures. A typical benchmark for an investment manager may, for instance, be expressed as a function of one or more market indexes or as a relative ranking within a universe of similar funds.

Measurements related to inflation or an actuarial rate of return, on the other hand, are more appropriate for the pension plan as a whole. A Canadian equity manager that achieves 4% return compared to a Toronto Stock Exchange 300 composite index return of -1%, but fails to beat inflation by 2% cannot be faulted for lack of management skill.

Conversely, over the last five to 10 years, achieving an attractive real rate of return has not been difficult. This illustrates that the real return objective is a poor measure of manager skill.

TAKING ACTION

Assuming underperformance has been achieved relative to stated performance objectives, which are both reasonable and appropriate, when is it the right time to pull the plug?

One of the facts committee members and trustees learn early in their involvement with a pension plan is that decisions they might make regarding their personal investments are rarely appropriate for pension funds. Significant portfolio holdings are not bought and sold for short-term gain. Pension fund managers are not hired and terminated with the revolving-door mentality often displayed by mutual fund holders.

Significant manager turnover can be extremely costly in terms of fund performance. It also consumes a considerable amount of time and effort on the part of plan fiduciaries, and can lead to claims of mismanagement by the beneficiaries of the plan.

Most individuals are also cognizant of the investment mantra, buy low, sell high. This can make committees reluctant to fire investment managers after periods of poor performance for fear of bottoming out on their losses. Add to that the often convincing explanations offered up by managers for their performance--and the promises of future turnaround--and it's not unusual for a committee to find itself hopelessly mired in indecision.

When faced with a dilemma regarding the retention or replacement of an investment manager, pension fiduciaries must ask themselves whether they are being fair and realistic. Managers should be given a reasonable amount of time to address what may be considered minor concerns, but when it comes to major concerns, committees must be willing to take the bull by the horns and act when necessary.

The bottom line for trustees and committee members is to be diligent in their monitoring and expect fair value for their investment. Committees should ask themselves these questions:

• Did we monitor our manager diligently by addressing the above issues on a regular basis?
• Did we discuss our concerns with our money manager?
• Did we follow our investment policy?
• Did we seek outside guidance where we lacked internal expertise?
• Did we place the interests of plan members above all else?

If the answer to each is an unequivocal 'yes,' pension plan fiduciaries will have gone a long way to avoiding claims of mismanagement--even when fund performance is lagging investment objectives.

Greg Malone is a consulting actuary and certified investment management analyst. He currently manages Eckler Partners Ltd.'s asset consulting practice. gmalone@eckler.ca.

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